Ask the Expert: AIG on captives

Is a captive the best use of capital in terms of risk financing?

We will continue to see captives being used to finance risk because they allow you to fund for those future losses. So whatever the trading environment is, you have provided for those future losses when they eventually come to be paid. It is a prudent way to address that often in a tax efficient manner. There are other ways – deductibles are a very cost effective way to address risk because they result in saving on premiums, IPT, fees, brokerage, as well offering cash flow benefits. But, when losses come to be paid, it could coincide with a period when the trading environment is not so good, and the funds have not properly been set aside.
Or organisations can simply transfer the risk to the market as capacity is currently readily available at a good price. But the captive gives you the flexibility to address the market changes which will inevitably come at some point.

How are captives affected by the soft insurance market?

Captive formations have taken place during hard and soft markets and usually once a client has elected to go down the captive route it is a long term strategy through the insurance cycle. Having said that, some clients have re-evaluated their captive and in some instances, chosen to close them down, as part of expense controls, capital management or organisational simplification strategies. This means that the client increasingly looks at their captive through a different lens. It is not a widespread trend, but we are seeing some questioning of captives and their future role in the organisation and whether there is a better alternative.
The danger is that once you go down the route of closing a captive, it is going to be much harder to change your mind later down the road when circumstances, or the market, change. So that is why many maintain their ongoing captive involvement in their programmes or look for ways to give it greater relevance to the organisation.

Are captives under greater scrutiny?

All corporations are now managing their capital more carefully, and their return on capital, in their various operations and that includes captive insurance subsidiaries. Captives are being challenged and held up to new standards, whereas perhaps in the past they continued from year to year largely unchallenged, because they had relatively stable results. They are certainly being questioned more than in the past both internally within the organisation and externally by the tax and regulatory authorities.

How much flexibility is there in captive pricing to use it as a risk management tool for rewarding/penalising good risk management practices in subsidiaries?

Captives do largely follow what is happening in the commercial market in terms of pricing, so it is not too easy to smooth out the ups and downs of the underwriting cycle with a captive. We provide benchmarking on pricing for captives, and getting guidance from brokers and insurers does help the captive with its pricing strategy. From a captive point of view, you want to see a relatively stable premium evolution in your underwriting strategy, rather than big rises and falls each year. Regulators are particularly concerned if they see great volatility in the business being written in the captive – not in the underwriting result but in its income.
Nevertheless, I think the captive can still reward good loss results and penalise bad loss results as part of a global programme. If a subsidiary in a country has seen bad losses, then it makes senses that for this subsidiary or country operation, the premium increases, or if there are good results, that the operation sees some benefit from that favourable experience. Ultimately, the risk manager has to ensure that the terms that are being offered to local operations do reflect the reality of their market and that the coverage being offered is broad and competitively priced.

Will the long term effects of BEPS and other tax-related rules be detrimental to captives?

Captives will respond to this challenge, but ultimately it will encourage them to ensure that their programmes are for the right reasons – risk management and risk financing, and not driven by other considerations. Tax should not be the driving force behind any captive programme.
As for domiciles, the attractiveness of a jurisdiction is normally driven by the regulatory regime and the capital requirements rather than about tax, partly because when results are consolidated those tax benefits can largely disappear.
If the captive was there for the right reasons, then BEPS and Solvency II have not been a major concern. Where the captive’s raison d’etre was something else, then it is now much harder to justify its risk financing and risk management role in today’s environment.